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SEC Watch: Making sense of Rule 151A

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As legal experts pour over proposed Rule 151A, insurance carriers are threatening legal action against regulation from the Securities and Exchange Commission. What are the legal issues? First, annuities are exempt from regulation under the Securities Act of 1933. Second, a Safe Harbor Rule 151 already exists which protects certain products from securities regulation. And third, a federal district court has already ruled that index annuities are not securities.

The SEC strategy is essentially to change the definition of an annuity by excluding index annuities. Changing this definition means the exemption which has historically pulled annuities out of securities regulation will no longer apply to index annuities, thus allowing the SEC to begin regulating index annuities. The SEC exemption applies to ‘dogs,’ so the SEC will start calling index annuities ‘cats’ to regulate the product.

A significant legal decision was handed down by the U.S. Supreme Court in 1967. In that case the Court examined whether a product was marketed on traditional insurance themes such as ‘safety’ and ‘security’ or marketed based on prospective growth through sound investment management. The Supreme Court concluded in both lawsuits that insurance regulation was not enough to keep the SEC at bay.

Conspicuously missing from the SEC proposed Rule 151A analysis is reference to one of the strongest court decisions against regulation of index annuities as securities. In 2002, a federal district court in Kentucky examined an index annuity issued by American Equity Investment Life Insurance Company. The allegation in 2002 was that the index annuity was an ‘investment contract’ under the Securities Act of 1933 and therefore subject to SEC regulation. Please note that the SEC proposed Rule 151A is not claiming that an index annuity is an ‘investment contract’ (which is an undefined security in the 1933 Act). Rather, the SEC is proposing that index annuities should be excluded from the definition of annuities. The SEC is trying to find an open window because the front and back doors have been dead bolted.

Although the lawsuit against American Equity was a tremendous win for the carrier and the industry, what is most significant is that the judge included in his opinion an analysis of why an index annuity meets the Rule 151 Safe Harbor criteria. By changing the definition of ‘annuity’ to exclude index annuities, the Safe Harbor Rule 151 will no longer apply to index annuities. The purpose of Rule 151 is to create a “safe harbor” for certain types of annuity contracts by making them exempt from the federal securities laws. Insurance carriers have purposely built index annuities to satisfy the Safe Harbor guidelines. Although the SEC has not definitively resolved the issue, the presumption is that most annuities are governed by the Rule 151 securities exemption. This is because most annuities function like insurance policies rather than investment securities, and Congress explicitly made insurance policies exempt from securities regulation.

Many are criticizing the timing of SEC proposed Rule 151A. It comes at a time when the insurance industry is working diligently to correct sales abuses and product knowledge gaps. The National Association of Insurance Commissioners (NAIC) has created a new working group to revise its suitability model. In addition, the Iowa Insurance Division is running a pilot program regarding annuity disclosure forms. Many carriers have also instituted new producer training requirements.

The SEC appears to be reacting to recent media coverage on abusive sales practices related to index annuities, not product issues. It is not calling for a change in regulation based on product design and has sat silent since its Concept Release regarding index annuities in 1997. The SEC’s renewed interest in index annuities stems from sensationalized journalism as noted by its rebroadcast of an unfavorable program relating to abusive sales practices during its open meeting in June. Unfortunately, bad news sells and many feel pressure to react. If the proposed Rule 151A goes into effect, it will mean many changes for producers and the industry.

Danette L. Kennedy is president of Gorilla Insurance Marketing Inc. She can be reached at .


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